Can Super Mario Draghi's run continue?

Features writer at City A.M. covering personal finance and trading. Reach me at katherine.denham@cityam.com.

The ECB will have to tread carefully as it weans Europe off the QE drug

Katherine Denham

The European Central Bank is ready to do “whatever it takes” to preserve the euro.

Those are the words of Mario Draghi in July 2012, when the euro had been pummeled over fears around the sovereign debt crisis.

The crisis began when the deficits of several European countries – including Greece, Italy, Spain, Portugal, and Ireland – had ballooned to dizzying heights, causing investor confidence to plunge and government bond yields to surge to unsustainable levels.

For those countries with hefty amounts of debt, lenders decided to ramp up interest rates. This put these regions in an increasingly sticky situation, increasing the cost of their debt burdens and therefore making it harder to plug their deficits.

Draghi pledged to alleviate the problem and introduced a string of radical measures, such as buying back troubled government bonds. He didn’t disappoint, and managed to keep the Eurozone intact.

It’s been five years since the head of the European Central Bank (ECB) uttered those famous words, but how do European investments look now?

Investors who believed Draghi would keep his word have reaped the rewards. Paul O’Connor, head of multi-asset at fund giant Janus Henderson, says that one of the great paradoxes of financial markets is that the worst times from an economic perspective, are often the best times for investing.

“During the summer of 2012, investors would have been well rewarded for looking through the gloom of the Eurozone financial crisis and taking faith in the confident pronouncements of Mario Draghi.

“Five years and a couple of trillion euros of ECB bond purchases later, the sovereign debt crisis has ended, bank lending has revived, and the Eurozone economy is enjoying its seventeenth consecutive quarter of growth.”

Looking at the MSCI Europe ex UK index, European equities have jumped by more than 107 per cent over the past five years, while European government bonds are up 36 per cent.

Yet it’s clear that there is a regime shift currently taking place in financial markets. O’Connor says that many of the policy-driven trends which have supercharged investor returns now look close to exhaustion.

“From here, investors need to recognise that returns in equities, bonds and credit are likely to be lower and more varied than in the past five years.”

Market rehab

Draghi might have helped reverse the Eurozone’s fortunes, but Darius McDermott of FundCalibre says that the central bank will eventually have to wean Europe off the QE drug by tapering the bond buying programme and raising interest rates.

When the ECB president hinted at such a move back in June, markets rattled: equities took a tumble, while government bond yields spiked. So it’s clear that Draghi will need to tread carefully.

And while the Eurozone is now stable, the ECB continues to miss its two per cent inflation target. This means that any tightening of policy is likely to be a long drawn-out process to avoid upsetting the balance, and O’Connor says the ECB will probably still be buying bonds into the second quarter of 2018.

Warning signs

This return to a normal monetary policy certainly signifies the burgeoning health of Europe’s economy, but there is a growing concern that it could be the red light for core European government bonds, meaning investors would be wise to begin looking to different types of debt instead.

In June, three European banks went under. Spain’s fourth largest bank, Banco Popular Espanol SA, was sold to Santander for €1 after the ECB concluded that it was no longer viable. The Italian government also bailed out Veneto Banca and Banca Popolare di Vicenza, at a cost to the taxpayer of €17bn.

While this might worry some investors, McDermott argues that the controlled way these failures were dealt with demonstrates how much more robust the system is compared to five years ago. And while bonds begin to look less appealing to investors, European equities are still going strong.

Healthy fundamentals

Far from being cautious, many market players see European equities as one of the most attractively valued asset classes at the moment, particularly relative to other developed nations such as the UK and US.

Inflation might be lagging behind the target, but deflation is no longer a concern, and consumption and employment numbers are improving.

Meanwhile, Europe looks far less prone to a shift towards populist politics compared to other developed nations, evident in the outcomes of the Dutch and French elections. This dilutes concerns that political upheaval could send the European markets spiralling.

So from an equity investment perspective, Europe looks healthy and is by far one of the most stable regions at the moment. McDermott remains confident, adding: “as long as global growth doesn’t stall, the next five years could also be rewarding.”

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.